On how credit excesses will undermine this cyclical upturn

I am not impressed with macro policy that is managed purely to give a cyclical boost to the economy at the expense of secular sustainability. That makes it hard to look at what’s happening with macro policy now without scepticism and criticism. I would like to say that the upbeat near-term forecasts are something to celebrate. But I can’t because they are predicated on unsustainable secular trends. A few brief thoughts below

A lot of what I write is about where the economy is headed. And as a result, it is more medium-term stuff that is devoid of a secular view. In that vein, what we see now is very good.

For example, while I warned in May that the intersection of real economy, monetary tightening and credit froth means volatility, I did write at the time that, “if the use of credit can overcome the decline in the leading indicators, 2014 will prove a mid-cycle slowing and markets will resume their climb, with a full-on bubble likely.” My point then was that even if you think that tightening into weakness is going to mean a slow economy, you have to understand that credit acts as an accelerator to the economy and the interaction of Fed policy, credit availability and private sector credit demand is dynamic. Tightening into weakness doesn’t necessarily mean an economic slowdown.

To wit, the OECD have released their latest figures for composite leading indicators. And what we see for the United States is a peak in October 2013 followed by a trough in February 2014. Since February, the OECD’s measurement of US composite leading indicators has been rising and through May is almost to the same level it was in October 2013, what I have been calling a cyclical peak in economic growth. The bottom line here is we have to let the data lead us. And the data are saying the US economy is expanding more rapidly and that the economy today looks better than when the year began. So that’s the one side of the coin.

When you look at the US economy from a secular perspective however, the situation is not rosy. Wage growth is low, household debt is high, monetary policy space is low, and fiscal policy political space is also low. What this means is that we have the makings of a household deleveraging in the next cyclical downturn without the policy space necessary to counteract that. And when you see the amount of froth developing in markets on a cyclical basis, you realize that this sets the US up for a nasty cyclical downturn.

The OCC, a weak US bank regulator, is even telling us that risk is increasing. In its semiannual risk perspective report, the Office of the Comptroller of the Currency wrote that competition was driving an easing in underwriting standards that showed signs of excessive risk, especially in leveraged loans and auto markets, two places I have mentioned repeatedly as areas where credit bubbles are forming. The OCC wants credit standards to ease, but not in a way that shows excessive risk taking. I highly recommend reading this document in full to understand the risks that are rising here.

One area I would like to call out is the compression in net interest margins. The OCC writes the following:

NIM remains under pressure as assets reprice at lower interest rates, but began to stabilize during 2013. The low interest rate climate continues to limit the ability of many banks to increase net interest income through volume. Consumer and commercial loans with pricing tied to short – term indexes are unlikely to show improvement until the federal funds rate begins to increase. Accordingly, with the yield curve steepening, the incentive for banks to increase loan volume by loosening underwriting standards or in vest ing excess cash into longer – maturity securities has increased, potentially increasing banks’ exposure to credit risk and IRR.

This is how I read this paragraph: as interest rates remain low, the long end of the curve is coming in and bank net interest margins are declining as higher priced loans expire and lower priced loans hit the books. If and when the Fed hikes rates, the rate hikes could actually pull forward credit growth because yield starved banks will ease to lock in margin. Given the already risky lending taking place in leveraged loans and high yield, it is likely that much of this credit will be malinvested money. And given the fact that bank loan loss provisions have declined pro-cyclically, we should expect a massive hit to balance sheets when the cycle turns down. This is what you should expect from easy money policies.

Some market players are concerned that spreads have become too tight and that the risk of a correction is building – but no one knows what catalyst might grind the machine to a halt.

Year-to-date high-yield returns are 5.7%, according to Bank of America Merrill Lynch data, which is far better than people expected at the start of the year.

“The market is so vibrant and nobody wants to let go of paper,” said Jon Sablowsky, head of trading at Brownstone Investment Group LLC in New York.

“But there is some concern that people are not doing their credit homework. At some point, I don’t know when, this cycle will eventually come to an end.”

He said some bonds in the technology sector, for example, were trading at levels that probably didn’t reflect their uncertain outlook. But he declined to name specific examples.

“It’s a bit overbought,” Sablowsky said.

Still, the primary market is thriving on the back of strong technicals.

This is all top of the credit cycle stuff. And it is all because interest rates are zero percent. So, for all of you saying the Fed needs to continue signalling risk-on with ZIRP just because unemployment is too high, I say you need fiscal policy for that. Monetary policy uber alles is not good policy.

Going back to cyclical economic forces, a hedge fund friend of mine wrote me the following:

If Q1 was truly simply seasonal, then we’d make a great deal of that back once the weather improved. That would argue, given the forecasts at the beginning of the year, for Q2 growth of at least 6%, to get us back on that track, but the kneejerk raises of Q2 estimates that we got today—Barcap and Goldie are what I saw—didn’t come close to that.

On jobless claims, it seems to me that we may absolutely have fired everybody we’re going to fire, and once all the dead wood has been cut, and you’re operating as lean as you can, jobless claims level off at a relatively low number, as they have. But there’s a big difference between that and the kind of economy that produces lots of well-paying jobs, which we clearly do not have, and don’t seem to be getting a lot closer to. Moreover, jobless claims have been in a range for longer than simply Q1, and Q2 hasn’t seen a “big comeback” in them.

As to the housing data, the white hot May new home sales were mostly driven by the southern region—266K homes in the south. Unfortunately for the bullish spin on this, that data did not reach the level of statistical significance, plus 14.2% with a 90% confidence interval of +/-27%–meaningless, in other words, pending better numbers. And yes, markets are forward looking, but at some point that argument loses force, does it not? Contracting economic growth, aka recessions, are horrible for corporate profits (as Q1 profit data showed), and continually rising stock prices in the face of falling earnings catches up to you eventually. Before this morning’s data, gdp growth from 2007 until today was 0.7% annually; that number gets revised lower after this morning’s data. Can we postulate that the trend rate of growth has slowed, and that thinking about a 2.5% trend rate can not be justified any longer, that even 1.5% as a trend growth rate is certainly not pessimistic? And given the rate of capital investment in the country, there’s little reason to forecast that to change, as far as I can tell.

Pimco’s new normal description seems pretty accurate to me. As to the assertion that it would be a mistake for the Fed to tighten, well, the only issue I have with that is that there’s no evidence I can see that its current policy has helped the economy one iota, except on the shortest of time frames, and, the problem with arguing counterfactuals aside, I can see lots of ways in which it has hurt, if the goal was to put the economy on a sounder footing for the long term.

I agree with the thrust of these (edited) comments. Here’s my (edited) reply:

As for my own skewed view, I agree with a lot of what you’re saying. I think it WASN’T all weather related in Q1 precisely because wage growth has been weak. You can’t have a recovery predicated on asset price inflation and debt accumulation without it being weak and unsustainable. 2% growth is the baseline here for me. The juxtaposition between almost record low debt service costs and still elevated household debt levels tells you something is seriously wrong. When full year 2014 ends, we will get 2% growth AT BEST. And that is growth mostly goosed by debt accumulation and asset-price froth.

I really don’t understand the New Keynesian view on this. They say the Fed should keep the spigots flowing full tilt as if it is the monetary agents role to save us from our own folly. That just makes it worse down the line. If the fiscal agents don’t want to get it done, why should the monetary agent come to the rescue? The Fed will just get blamed when things fall apart. And then Krugman and all the other New Keynesians will ask for more stimulus to sustain even more debt accumulation without even questioning the bankruptcy of that approach. We need (more) credit writedowns and wage growth or its just Potemkin recovery.

My view is that this is a recovery based on a cyclical bull market within a larger secular bear market. When the credit cycle turns down, all manner of hidden losses will come into view and the downturn in asset prices will be severe. That’s going to mean crisis. That’s my baseline view. In the meantime, I remain open to what the data tell us. Right now they say things are headed up. Let’s see how long that holds.

Ed

PS – Peak numbers across a spectrum of macro data is bearish since these numbers are mean reverting. We are not there yet but getting close. Look at jobless claims, PMIs and sentiment data. They are near cyclical peaks. These data can’t all continue higher. Some are going to mean revert and then we’ll have to see where job and wage growth and inventories are when they do. If jobs and wages are still nowhere and inventories are high, you have the potential makings of a downturn. I am looking for the upturn to last through at least mid-2015 if not longer though. Grantham makes persuasive points that a Presidential cycle will sustain it.

So, my view here is that a recovery in which monetary policy is normalized sooner, in which fiscal policy does more cyclical heavy lifting – even if only through automatic stabilizers – and in which wages underpin debt accumulation, is sustainable across cycles. A recovery predicated on asset-based gains, debt accumulation without concomitant wage gains and monetary ease is just bubble blowing.

As for Q1, I wrote my hedgie friend:

Here’s the thing: if the US economy was contracting at an annualized 3% rate in Q1 and no one was screaming bloody murder at the time, it makes how much clawback we’ve had somewhat irrelevant. The big takeaway is that the economy was SO weak in Q1 that we saw a 3% annualized decline. That’s HUGE and it’s not just a blip that is weather-related. It is a sign of underlying weakness. I don’t think we can overlook that by just saying this is rear-view mirror stuff.

Yes, the economy is going to expand briskly here for a quarter or two. Nonetheless, I am not at all convinced the underlying strength in the economy will sustain more. To the degree we do see more strength, we want it to come from wage gains – that to a degree will erode corporate profitability – rather than from debt accumulation and monetary ease. Now that credit excess is plain as the nose on your face, any strength in the economy that is not underpinned by median income gains will be given back as malinvestment when the credit cycle is unwind. And that is the sort of thing that precipitates crisis.

The most positive thing I can say here is that we could get some wage gains soon, if the Fed eases long enough. But I believe the credit excess will overwhelm these gains and then we’ll be in a serious downturn. Sorry to be bearish, but that’s how I am seeing it. As good as this feels now, it is more economic sugar high than real economic sustenance.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator in print and on television for the past decade. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.